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The Interaction of Entrepreneurship and Institutions Magnus IFN Working Paper No. 830, 2010 The Interaction of Entrepreneurship and Institutions Magnus Henrekson and Tino Sanandaji Research Institute of Industrial Economics P.O. Box 55665 SE-102 15 Stockholm, Sweden [email protected] www.ifn.se * The Interaction of Entrepreneurship and Institutions Magnus Henrekson1 and Tino Sanandaji1,2 April 15, 2010 Abstract: Previous research, notably Baumol (1990), has highlighted the role of insti- tutions in channeling entrepreneurial supply into productive, unproductive or destruc- tive activities. However, entrepreneurship is not only influenced by institutions— entrepreneurs often help shape institutions themselves. The bilateral causal relation between entrepreneurs and institutions is examined in this paper. Entrepreneurs affect institutions in at least three ways. Entrepreneurship abiding by existing institutions is occasionally disruptive enough to challenge the foundations of prevailing institutions. Entrepreneurs sometimes have the opportunity to evade institutions, which tends to undermine the effectiveness of the institutions, or cause institutions to change for the better. Lastly, entrepreneurs can directly alter institutions through innovative political entrepreneurship. Like business entrepreneurship, innovative political activity may be productive or unproductive, depending on the incentives facing entrepreneurs. JEL Codes: L5; M13; O31; P14. Keywords: Entrepreneurship; Innovation; Institutions; Regulation; Self-employment. 1 2 Research Institute of Industrial Harris School of Public Policy Economics (IFN) University of Chicago Box 55665 1155 East 60th Street SE-102 15 Stockholm 60637 Chicago IL Phone: +46-8-665 45 00 Fax: +46-8-665 45 99 e-mail: [email protected] [email protected] * This paper builds on work that originally included Robin Douhan as a key contributor. Robin unexpectedly and tragically passed away on 10 August 2009. His death, at the age of 31, was caused by sudden heart failure. His friendship, kindness and talent are deeply missed. Our profound intellectual debt to Robin is hereby acknow- leged. Financial support from the Jan Wallander and Tom Hedelius Research Foundation and from the Gustaf Douglas Research Program on Entrepreneurship at IFN is gratefully acknowledged. We are grateful for useful comments and suggestions on earlier versions of this paper from Johan Almenberg, William Baumol, Selva Baziki, Niclas Berggren, Pete Boettke, Dan Johansson, Linda Nyberg and two anonymous referees. 1. Introduction It has been recognized for some time that institutions shape the actions of entrepreneurs (e.g., Parker, 2004, ch. 3). Yet Baumol‘s seminal work (1990) contributed to the literature by show- ing that institutions determine not only the level, but also the type of entrepreneurship. Indi- viduals put their entrepreneurial talent to use in activities that are productive, unproductive or destructive. The institutional setup or ―the rules of the game‖ dictate relative return, and hence the allocation across these activities. However, institutions do not merely control entrepre- neurs, entrepreneurs control them—through business activity, evasive methods and political entrepreneurship. This paper will explore both sides of this interaction: how the institutional framework influences entrepreneurship and how entrepreneurs in turn influence the emer- gence and evolution of institutions. An influential stream of research has built on the insight that productive abilities can also be used for rent-extracting purposes (e.g., Murphy, Shleifer and Vishny 1991, and Acemoglu 1995). This literature typically stresses that institutions determine the relative rates of return of productive and unproductive types of activities. This relationship has typically been as- sumed to be unilateral, running from institutions to entrepreneurship, while a potential reverse or bilateral causality has been largely neglected.1 Yet entrepreneurship does interact with institutions within the course of a bilateral relation- ship. This possibility has been touched upon previously in the public choice school. Buchanan (1980, p. 14) noted: Faced with a prospect of differentially unfavorable tax treatment by government, a person or a group may (1) engage in lobbying effort; (2) engage directly in politics to secure access to deci- sion-making power, and/or (3) make plans to shift into or out of the affected activity. In general terms, Buchanan concludes that entrepreneurs affect institutions by: (i) market in- novations that alter institutions or the effect of institutions; (ii) evasion of institutions; and (iii) direct political entrepreneurship. 1 Boettke and Coyne (2009) thoroughly analyze the link between institutions and entrepreneurship (and also offer a comprehensive review of the related literature). Boettke and Coyne (2003) probably contains the strong- est assertion that institutions are the ultimate cause of growth, whereas entrepreneurship is merely a proximate cause, since according to them its supply and direction is fully determined by the institutional setup. 1 2. Entrepreneurship Defined and Categorized 2.1 Entrepreneurial Talent In line with Baumol (1990) and Murphy et al. (1991), an entrepreneur is defined here accord- ing to a set of talents. There is no consensus in the literature regarding the nature of these tal- ents; some scholars emphasize cognitive abilities while others point to motivation (prefe- rences).2 We define entrepreneurial talent as a combination of perceptiveness, the ability to detect opportunities, and the capability of undertaking new ventures in response. The defini- tion thus includes both motivation and ability. Profitable business projects, the chance to ap- propriate or earn rents and the possibility to affect policy constitute the opportunities explored here. Self-employment and start-ups embody the most typical forms of business entrepreneurship. Our definition of entrepreneurship precludes many forms of self-employment, however. Most importantly, self-employment that is not innovative in nature does not qualify as entrepre- neurship. In reality, no clear boundary delineating truly innovative entrepreneurship from non-innovative self-employment can be drawn; as a result, we employ a continuum of self- employment activity organized from purely non-innovative to highly dynamic entrepreneur- ship. The idea that innovative individuals contribute to institutional change has a long history in political science. In his case study of political power in New Haven, Dahl (1961) introduced the term ―political entrepreneurs,‖ individuals who recombine resources in the policy arena to bring about change. The political arena in New Haven was entrepreneurial in its alertness to ―citizen desires‖ and ―the ease with which the political stratum can be penetrated‖ (Dahl 1961, p. 93) by new individuals. In accordance with political scientists, we also call entrepre- neurship undertaken with the direct aim of altering institutions political entrepreneurship.3 2 Research on typical entrepreneurial properties focus on two major themes: cognitive abilities and motivation. The model entrepreneur is someone who is alert to opportunities. Cognitively, this amounts to efficiently struc- turing abundant information in order to make feasible judgments (Gaglio and Katz, 2001). It also involves a capacity to think in novel ways (Ward, 2004). In regard to motives, the longest standing characterization of an entrepreneur is associated with the need to achieve and create (Weber, 2001[1905]; McClelland, 1961). Further- more, an entrepreneur exhibits a willingness to take calculated (but not necessarily calculable) risks. Knight (1921) claims that the ability to cope with uncertainty is the main function of entrepreneurship. For a survey of empirical evidence on these motivational aspects, see Rausch and Frese (2000). These properties are consistent with the historical accounts in Schumpeter (1934) and Kirzner (1973, 1992). 3 Van der Steen and Groenewegen (2009) distinguish between political entrepreneurship, institutional entrepre- neurship and policy entrepreneurship. In order to avoid an overabundance of definitions, we use political, institu- tional and policy entrepreneurship interchangeably. 2 The term business or market entrepreneur is used here, somewhat loosely, to refer to tradi- tional Schumpeterian entrepreneurs, distinct from political entrepreneurs. Similar to business entrepreneurs, political entrepreneurs are people who are alert to opportunities, bear risk, reorganize coalitions and resources, and ultimately bring about innovation, be it socially posi- tive or negative. Despite clear differences in undertakings and goals, business and policy entrepreneurs enjoy similar functions. Law-abiding business entrepreneurs and institution-altering political entre- preneurs both discover and meet unfulfilled needs, and both must bear the personal risk asso- ciated with their ventures. Lastly, all entrepreneurs need to coordinate and reorganize the re- sources needed to undertake change, be it capital, labor or political alliances. In light of these parallel functions, it is likely that all types of entrepreneurs share at least some individual cha- racteristics. Lee Kuan Yew, Robert Mugabe and Silvio Berlusconi are some of the major political entre- preneurs discussed here. While they are quite obvious examples, Lee, Mugabe and Berlusconi only form the tip of the iceberg of political entrepreneurship. Innovative political activity oc- curs constantly on all levels of government.
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